what does purchasing power parity mean?

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what does purchasing power parity mean?

In: Economics

If you take the exchange rate of two currencies into consideration, then certain commodities that are globally available will have different prices based on their location. The difference in price is called the purchasing power parity.

Look up The Economist Big Mac index. They take the price of a Big Mac across the world and compare it against the current exchange rates. Convert all of the prices to US$ and the different prices reflect how much a US$ will buy in different areas. I think of it like a cost of living difference.

Pretty simple really; the same goods and services can cost more in one place than in another and PPP seeks to adjust for that. Think of it like how a 100,000 salary in the South can give you a decent life, but in San Francisco you’d be considered below the poverty line. Except PPP is based on country wide statistics and international exchange rates.

Let’s say you go to a Walmart in the US and buy three items – a loaf of bread ($3), a pound of onions ($4) and a can of Coke ($10). Overall, it costs $17.

Let’s then say a family member of yours is in India. They want to buy the same three things, but are super broke. You decide to give them $17 but in Indian Rupees as that’s how much it cost you in the States.

Now, $1 is about 75 Indian Rupees. So, at their end, they receive 1,275 Rupees.

They head to a grocery store and buy the same three items. A loaf of bread (Rs. 25), a pound of onions (Rs. 15) and a can of Coke (Rs. 40), for a grand total of Rs. 80 or $1.07.

So, with $1 and change, your family member in India could buy what cost you $17.

In other words, all other things being equal, $17 in USA is the same as $1 in India. The purchasing power parity of an Indian Rupee, with respect to the US Dollar, is 17.

Now the problem is that different items would have different levels of parity. A Samsung Galaxy S21 would be more expensive in India, than it is in USA.

So, to give people a general idea of parity levels, economists choose a large group of items that are frequently bought in both places, add them to their carts, and provide a ‘PPP’ value based on how much the same cart cost in each country.

Let’s say you want to compare median family income in Guilder and Florin. In Guilder, median family income is 1000 lucres. In Florin, it’s 2000 whizbangs. So to compare, you gotta convert lucres and whizbangs.

You could use the exchange rate, how many whizbangs it costs to buy a lucre on the open market. If the exchange rate is 1.5 whizbangs for a lucre, then MFI in Guilder is 1000 lucres and in Florin it’s 1333. Families in Florin are somewhat better off.

But exchange rates can be manipulated by governments for their own purposes. So you might instead use PPP. A simple way to do this is to just divide the each MFI by the average cost of a Big Mac in each country. If you do this, you find the median family in Guilder earns 3800 Big Macs per year while the median family in Florin earns 3400. So looking at it this way, families in Guilder are better off.